Following the immediate shock to the markets on the outcome of the vote, global equity markets had largely recovered back to pre-referendum levels barely a week later, leaving the main casualty sterling, which was always going to be the pressure release valve.
Despite the turbulence in markets, I do not believe the economic predictions from either campaign had any real validity, and despite an expectation for a short-term hit to gross domestic product, the underlying economic impact is likely to be limited in the wider context of long-term global growth. Within the UK, we have seen differentiation as the FTSE 100 staged a rapid recovery, while mid and small-sized companies, which tend to be more tapped into the UK economy, languished. Investors with globally diversified multi-asset portfolios may be surprised to learn that they have probably done surprisingly well in their portfolios despite the negative headlines, if they have left their overseas exposure unhedged.@Image-81abee18-53bd-4285-b5d1-dfaf1805beaa@
The true economic impact of the UK leaving the EU is effectively unknowable, but in the grand scheme of things we expect the impact to be relatively limited – economies and their agents will adapt, and the shock of the result will dissipate over time. Our own view is that markets are likely to remain skittish, given the political uncertainties within the UK and across Europe, until visibility improves on who will succeed David Cameron as prime minister, their negotiating stance on a future relationship and how the conflicting motivations of EU officials develop. From an investment point of view, we see the weaker pound as a positive for UK-listed and sterling-based multi-national companies which can repatriate overseas earnings at more beneficial exchange rates.
With the referendum over, we expect markets to get back to focusing on more substantive issues, which we have been continuing to monitor carefully even while much attention has been temporarily diverted. At the top of the list is how the US Federal Reserve manages US interest rates. We think the Fed has created a no-win scenario for itself, as its preferred measures of inflation and employment are approaching its targets just as profitability at US corporations seem to be coming under pressure. It now faces the risk of either accelerating the onset of recession by hiking too quickly, or letting an economic malaise take hold without the traditional re-boot mechanism of cutting interest rates.
A less probable – at least in the near term – but higher-impact risk is a disorderly unwind of the debt bubble that has been fuelling Chinese growth for the past decade. Sharp but brief falls in global equity markets last summer and again at the start of this year provided a taster of what could happen if China continues to play fast and loose with its capital allocation.
Against these concerns, we continue to see pockets of opportunity, with policy stimulus continuing to be a key driver of markets in the near term.
One key aspect of the EU referendum worth holding on to is the growing impact politics will play in the formulation of macroeconomic policymaking. Globally we are seeing anti-establishment rhetoric growing as extraordinary monetary policy drives an increasing sense of social inequality. Asset price inflation has materially exceeded wage growth for a prolonged period, giving rise to the perception that policy is being set for the benefit of the few at the expense of the many.
Not only is political instability likely to drive volatility in markets, there are also worrying signs of a growing appetite for government interference in the actions of nominally independent central banks, just as the unconventional monetary policy experiments extend further into the unknown. Uncertainty around how the UK actually leaves the EU and on what terms, will remain for the foreseeable future, but is likely to fade into more of a background process. There is no doubt that these are unnerving times and we are now in for a prolonged period of political and economic uncertainty, with periods of market volatility likely.
It is time for investors to keep a cool head, focus on the long term and retain a bias towards funds that concentrate on liquid, high-quality companies with strong and visible cash flow generation and international earnings. While some sectors such as financials and property are going to be impacted by ongoing uncertainty as the UK’s future relationship with the EU is fleshed out, more than 70 per cent of FTSE 100 earnings are made outside the UK, providing some cushion to any near-term weakness in UK growth.
With the FTSE 100 yielding 4.2 per cent at a time when 10-year gilt yields have fallen below 1 per cent as expectations of further monetary stimulus have gathered pace, this yield gap should also underpin UK large-cap equities. These companies typically earn the majority of their revenues outside the UK, so the weakness in the pound should be supportive to them as they translate dollar earnings into sterling profits and dividends.
We therefore think it is sensible to focus more on this end of the market, through well-managed funds focused on large, liquid, high-quality stocks such as Evenlode Income and JO Hambro UK Opportunities. There will of course be selective opportunities in mid-sized and smaller companies that have been indiscriminately sold off, but we remain cautious on domestic cyclicals. A fund that provides exposure to large, mid-sized and smaller growth companies with resilient business models is Liontrust Special Situations, which has historically performed well in down markets.
Of course, there is more to investing than just equities, and for those looking to add a bit more caution, or who simply want to avoid investing in particularly volatile equity markets, there are now a number of absolute return funds that have come of age. Both Invesco Perpetual Global Targeted Returns and JPM Global Macro Opportunities funds have proven themselves more than capable of providing cost-effective returns with low correlation to equity markets.
Ben Seager-Scott is director of investment strategy and research of Tilney Bestinvest
Key Points
Global equity markets largely recovered back to pre-referendum levels a week later.
We expect markets to get back to focusing on more substantive issues.
It is time for investors to focus on the long term and retain a bias towards funds that concentrate on liquid, high-quality companies.
